Junk borrowers face tough months

Jan 14, 2014

OGX’s default, increasing benchmark rates and a turning macroeconomic cycle are set to make borrowing more difficult for sub-investment grade companies this year, say portfolio managers

High-yield
credits are poised for months of turbulence as investors demand
more compensation for their risk amid rising borrowing costs
and as commodity prices and economic growth moderate across the
region.

This
comes at a time when fund managers are growing more sensitive
to the hazards of investing in emerging market high-yield debt,
following last November’s high-profile bankruptcy
– the largest in Latin American history – of
Brazilian oil firm OGX.

"This
case in a relatively short period of time will establish how
much of a premium one should ask for investing in emerging
market corporate debt, taking into account weaker legal
framework," said Polina Kurdyavko, senior portfolio manager at
BlueBay Asset Management, which is not an OGX
bondholder.

"We
always knew the framework was weaker [in emerging markets], but
it was always difficult to assign a spread pickup," she
added.

OGX’s
troubles are "clearly negative" for perceptions of the asset
class, said Darin Batchman, a portfolio manager at Stone Harbor
Investment Partners, which manages $63 billion in
assets.

While
"the last few years have allowed [high-yield borrowers] access
to the capital markets and long-term financing at attractive
rates," they are now "subject to rising interest rates, as are
companies all over the world," Batchman said.

But he
added that most major companies in the region nevertheless had
solid fundamentals. "The majority of Latin American corporates
are very solid, well positioned, and protected from FX moves,"
he said.

Robert
Abad, portfolio manager at Western Asset Management, said that
although benchmark rates are likely to rise this year, they
will remain low from a historical perspective. Emerging market
high-yield assets will therefore retain their appeal, he
added.

Abad
nevertheless called attention to a range of factors that will
determine investor demand for high yield credit.

"Jurisdictional
risk is still a very opaque area when investing in emerging
markets simply because we haven’t seen more
natural cycles in the past five to 10 years which would have
aided in the evolution of bankruptcy and restructuring
frameworks," he said.

That
opaqueness means that issuer-specific factors —
business model, operating record, and management experience
— will tend to determine risk premiums, he said.
Investors must research firms thoroughly to avoid ending up
with defaulted paper.

"People forget
that bankruptcies and restructurings can be protracted affairs.
This is important, as growing legal costs over time could make
the 'all-in’ recovery value much lower than what
was initially anticipated," Abad said.

Default rates
among high-yield companies in Latin America and the Caribbean,
meanwhile, are on the rise, reaching 2.8% in mid-2013,
according to Standard & Poor’s. That was up
from 2.45% a year before and well above the overall emerging
market default rate of 2.3%. LF